Islamic Modes of Financing Ijarah (II). Summary of the Previous Lecture In previous lecture we...

Islamic Modes of Financing

Ijarah (II)

Summary of the Previous Lecture

In previous lecture we discussed the following;

1. Background of Ijarah contract

2. Applications of Ijarah• property financing • vehicle financing• project financing • personal financing• structured products

4. Definition and types of Ijarah

5. Shariah Legitimacy of Ijarah Contract

Summary of the Previous Lecture

6. Features of Ijarah Contract

6.1 Usufruct and services

6.2 Asset for Ijarah

6.3 Ownership rights and liabilities

6.4 Utilization of leased assets

6.5 Lease period

6.6 Rental amount and payment

Learning Outcomes

After this lecture you will be able to understand the;

1. Background of Ijarah contract

2. Applications of Ijarah• property financing • vehicle financing• project financing • personal financing• structured products

4. Definition and types of Ijarah

5. Shariah Legitimacy of Ijarah Contract

Learning Outcomes6. Features of Ijarah Contract





6.5 Lease period


7. The situation of default and compensation in Ijarah

8. Nature of promise in Ijarah arrangement

9. How cancellation of Ijarah contract takes place

10. Concept of selling of the leased assets

11. Concept of takaful for Ijarah assets.

6.4 Utilization of Leased Assets1. The transfer of usufruct of leased asset from lessor to lessee

is valid from the Shariah perspective. However, it will be

based on the permissibility of core activity of the lessee

whether it is Shariah compliant or not.

2. The lessee shall observe the terms and conditions of the

utilization of the leased asset until the expiry of the lease

period or the termination of the lease as agreed by both

parties, whichever is earlier.

3. The lessee shall use the leased asset only for the purpose

specified in the lease agreement.

6.4 Utilization of Leased Assets

Illustration: Permissibility of Usage of Leased Assets

Airline “A” leases a passenger aircraft from Company “E”.

After using the aircraft for several years, Airline A intends to

convert the aircraft to a cargo aircraft to transport goods.

Airline A has no right to do so without the permission from

the owner of the aircraft which is Company E.

6.4 Utilization of Leased Assets

4. If the agreement does not specify the purpose of the

lease, the lessee may use the leased item for whatever

permissible purpose according to the customary

practice of the market.

5. The lessee shall obtain permission from the lessor if the

leased asset is to be used for permissible purposes

other than its common utilization according to the

customary practice.

6.4 Utilization of Leased Assets6. The asset shall not be leased to a person or entity if it is

known or if there is a very high probability that the leased assets are to be used for non-Shariah compliant activities.

7. The lessee shall be liable for any variation from the permissible use of the leased asset for a purpose which is against the Shariah. In such a case, the lessor may terminate the contract or seek other legal recourse as a remedy for the breach.

8. The terms and conditions on the use of the leased asset specified by the lessor may allow the lessee flexibility to increase, enhance, extend or expand the use of leased asset including lease payment considerations.

6.4 Utilization of Leased AssetsIllustration: Contract Variant in Usage of Leased Assets

An IFI enters into a lease contract with a courier company

to transport specific volume of goods at a specific rental

rate for a specified period. It is agreed by both parties, in

case where the volume exceeds the agreed volume in the

contract, the lessor is entitled for additional rent from the

excess volume at a higher rental rate agreed by both

parties. The two-tier rate is agreed and specified to enable

flexibility in the lease agreement.

5. Lease period1. The period of lease shall be agreed and specified as per

the terms of the contract.

2. The lease period shall effectively commence from the

time the lessee has the access to the usufruct of the

asset regardless of actual utilization of the asset.

3. The lease period shall terminate at maturity of the

period or if the asset is impaired in terms of its function

or utility or when both parties mutually agree to cancel

the contract.

6. Rental amount and payment

1. The rental payment may be made in cash, kind or in the form of services.

Illustration: Lease Payment in Services

ABC Cleaning Services Co. which operates cleaning services leases an office space from XYZ Holdings. The rental of the office space is Rs.20, 000 per month. At the same time, XYZ Holding engages ABC to provide cleaning services for its premise and the contract value for such services equals to Rs.20, 000 per month. XYZ Holdings agree to accept the cleaning services provided by ABC Cleaning Services Co. as the lease payment of the office space.


Illustration: Lease Payment in Kind

A property owner granted permission to another party to

build and to subsequently lease the building from the owner

for a definite lease period. During the lease period the party

benefited from the occupancy of the building and the land

without any payment made to the owner. At the end of the

lease period, the building and land were returned to the

owner. Therefore, lease in form of benefit in kind can be

agreed between the property owner and the lessee.

6. Rental amount and payment 2. The rental or lease amount shall be determined upon

acceptance of the offer of the lease contract.

3. The amount of rental specified and mutually agreed for

the lease period shall not vary during the period. Any

variation such as rental benchmarked to market rate or

index is prohibited. However, a periodic review of the

rental amount may reflect the market rate or any agreed

benchmark upon renewal of contract for subsequent

lease periods.


Illustration: Variable Rate

In view of the uncertain economic conditions and volatile market prices, an Islamic bank is prepared to lease a property with the rental amount reviewed every two years based on market rental rates to a tenant with an option to purchase the property during or at the end of the lease period. The master agreement specified that the lessee is prepared to lease the asset for 10 years with bi-annual review of the rental amount. The lease contract is renewable every two years. In this manner, the overall rental rate reflects the market rental rates during the lease period.


4. The rental amount may vary on a daily basis provided

that such variation is based on benchmark made known

and agreeable to both parties.

5. In a leasing agreement whereby the leasing period is

divided into a number of phases, the rental rate

specified in each phase may vary for different phases

during the lease period, provided that the amount of

rent for each phase shall be specifically agreed upon at

the time the lease takes effect.

6. Rental amount and payment 6. There should be a rent adjustment in the Ijarah contract

to facilitate the multi-phase rates of Ijarah for renewal in

subsequent phases. The rental rate adjustment may be

in the form of a specified rent escalation or may be

indexed to a certain index, such as the consumer price

index or may also be adjusted according to a certain

percentage at the end of an interval of a specific period.

7. No rental payment may be collected or received or

earned until the usufruct is established and transferred

to the lessee.


8. Rental payment or any part thereof received in advance

at the beginning of the tenur of the lease or before

effective delivery of the asset to the lessee is

permissible and shall remain a liability until the usufruct

is established and transferred to the lessee. The

advance rental shall be adjusted towards the rent

earned after lease payment is due.


9. Security such as charge over assets or a third party

guarantee may be required from the lessee to secure

rental payment.

10. In case of foreclosure of the charged asset, the lessor

may recover unpaid rental for usage of the leased asset

from the proceeds of sale of the security.

11. The IFI may credit some amount of money to the

account of the lessee under Ijarah as a Hibah for timely

payment of all the rental payments.

6. Rental amount and payment Illustration: Periodic Review of Rental Rate

In a lease agreement, the lessor in anticipation of future appreciation of property prices specified a rental adjustment clause that allows for periodic review of the rental rate during the construction and leasing of the property. During the two year construction period, the lease payment is fixed. After completion of the property, the rental rate is determined subject to review every two years. For example, a fixed lease payment of Rs.50, 000 per month is agreed during the lease period. Subsequent to the construction period, lease payment of Rs.60, 000 per month is agreed for two years and the lease renewal is subject to the property price appreciation. Upon renewal, the property value has appreciated by 10% and the lease payment is adjusted to Rs.66, 000 per month.

6. Rental amount and payment 12.The lessor shall not increase the rent unilaterally. Any

pre-agreement to give this right to the lessor will render the contract null and void.

13.The lease payment may be in instalments or in lump sum subject to the agreement by the contracting parties.

14. If the lessee stops using the leased asset and returns it to the owner without the latter’s consent, the lessor shall have the right to demand the rental payment until the end of the lease period. During the remaining period, the lessor shall not be allowed to lease the asset to another party.


15. An Ijarah contract may be executed on the

same tangible asset in different mutually

exclusive periods and by different lease

contracts. Thus two contracts shall not be

executed with respect to the same asset for

the same period.

7. Default and Compensation1. Any outstanding rental payment of an existing Ijarah

contract as a result of default shall be deemed as debt due from the lessee and shall be subject to all the rules prescribed for defaults in the payment of debt for the defined lease period. The lessor shall not charge any additional amount as income in case of delays in payment of the rental, any additional amount charged as penalty for late payment will be used for charity.

2. Any compensation for actual loss incurred as a result of the default and delinquencies in payment of debt may be claimed by the lessor.

7. Default and Compensation

3. IFI may claim any legitimate compensation caused by

breach of contract by the lessee from the cash proceeds

of sale of the security.

4. IFI may include a clause in the Ijarah contract, stipulating

a “compensation for late payment” which is claimable by

the IFI from the customer as income or a clause

stipulating penalty which shall be channeled to charity.

5. The lessor may seek compensation for any loss caused

by misuse or negligence on the part of the lessee.

8. Promise in Ijarah Arrangement

1. The unilateral promise by the lessee to lease the asset

from the IFI upon the latter’s acquisition or construction

of the asset shall be binding on the lessee.

2. The promise shall be separately executed prior to the

execution of Ijarah contract.

3. The IFI may require the customer to pay a security

deposit as a guarantee which protects the IFI from the

risk of the customer not fulfilling the unilateral promise

to lease the asset upon purchase by IFI.

8. Promise in Ijarah Arrangement

4. In case of a breach of promise, the IFI may claim the

actual loss from the amount of security deposit.

5. In a situation where there is no breach of promise, the

security deposit may be used to adjust part of the rental

payment of the leased asset.

6. The lessor may promise to sell the leased asset to the

lessee at a mutually agreed price. Alternatively the

lessee may promise to purchase the leased asset from

the lessor at a mutually agreed price.

8. Promise in Ijarah ArrangementIllustration: Promise to Lease From Lessee

Mr. A requests from an Islamic Bank to purchase machinery and subsequently promise to lease the machinery from the bank. The bank requires Mr. A to pay security deposit of Rs.50,000. Upon the bank’s acquisition of the asset, Mr. A refuses to lease the machinery from the bank. In such a situation, the bank can dispose the asset and claim for any loss in value from such disposal as well as other costs incurred due to failure to fulfill the promise. The loss in value and related costs shall be compensated from the security deposit. Any balance from the security deposit shall be returned to Mr. A. If Mr. A proceeded with the lease contract, the security deposit can be considered as part of the lease payment due to the bank.

9. Cancellation of the Ijarah Contract

1. The Ijarah contract is a binding contract; neither party

may terminate the contract without the consent of the

other party. Hence, any clause for the lessor to

terminate the lease without the consent of the lessee

shall not be valid except in the case of breach.

2. The lessor may terminate the Ijarah contract unilaterally

for any violation or breach of any term of the agreement

by the lessee.


Illustration: Lessee Liability Resulting in Termination

ABC Co. leases ten buses for one month from XYZ Co. for different destinations. The buses were handed to ABC after the signing of the lease contract with all the buses functioning well. After ten days of using the buses, one of the buses was grounded as the engine was severely damaged and could not be repaired. Another bus was damaged as ABC Co. parked the buses at an unsecured place. For the first scenario, in which one of the bus was not functioning, ABC Co. shall terminate the lease contract for the said bus as the usufruct has ceased to be in existence and in the second occurrence, ABC Co. has to bear the cost of repairing the damaged part as it happened due to their negligence.


3. An Ijarah contract may stipulate an option for either or

both parties to confirm or cancel the contract during a

specific period of time agreed upon by both contracting

parties.

4. Upon termination of Ijarah contract as per the

agreement or mutually agreed by both parties, the

rental for the remaining unutilized period of Ijarah shall

not become due from the lessee.


5. Upon the death of either of the contracting parties of an

Ijarah contract, the legal heirs may then exercise the

right to continue or to terminate the contract.

6. Lease agreement will terminate in case the leased asset

cannot render the benefits due to the lessee, but the

lease agreement may continue if the lessor can provide

an alternative asset to be leased agreeable to the

lessee.


7. A lease arrangement may be renewed by signing a new

contract with revised conditions and details.

8. The contract may also be renewed automatically, by

adding a provision in the Ijarah contract that such a

renewal shall take place with existing conditions when

the existing period lapses unless either party expresses

their intention to end the contract.

10. Selling of the Leased Asset

1. The lessor may sell the leased asset to any other party

except in the case of promise to sell the asset to the

lessee.

2. The lease agreement shall be terminated upon the

conclusion of the sale contract between the lessor and

the lessee and the legal title of the asset shall be

transferred to the lessee.

10. Selling of the Leased Asset

3. Unless agreed otherwise, the lessor is not required to

ask the permission of the lessee if the leased asset is

sold to a third party during the period of the lease.

4. In the case where a third party as purchaser was not

informed of the existing lease agreement on the asset

prior to the execution of such a sale, the purchaser may

cancel the sale contract.

11. Takaful for Ijarah

1. The lessor may mitigate other risks relating to physical

damage, theft or loss on destruction of the leased asset

by participating in a takaful scheme. The cost shall be

borne by the lessor.

2. The lessor may include the cost of the takaful

contribution in the Ijarah rental which is subject to a

periodic rental rate review including any escalation in

the takaful contribution.

11. Takaful for Ijarah

• The takaful coverage for the leased asset shall be borne

by the lessor as the owner of the asset; however, the

lessor can delegate the task of payment of the takaful

contribution to the lessee with a provision that this

amount shall be reimbursed from the lessor.

Summary of the Lecture6. Features of Ijarah Contract





6.5 Lease period


7. Default and Compensation

8. Promise in Ijarah arrangement

9. Cancellation and termination of Ijarah contract

10. Selling of the leased assets.

11. Takaful for Ijarah assets.

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